2 Top Reasons that an LLC or S-Corp Filing Can Reduce your Tax Bill

When a new client comes to meet me for the first time, I want to get him back on track so that he doesn’t incur tax debts in the future. No matter how he chooses to resolve his taxes, if he continues to incur new tax debts, then his strategy will go awry.  For example,

  • If he files a bankruptcy case, and continues to incur tax debts, then the Bankruptcy Court could dismiss his case;
  • If he enters into an IRS Installment Agreement (payment plan), and then in future years, incurs new debt, then again, the IRS will deem his Installment Agreement to be in default, and
  • If he gets approved for an Offer in Compromise, and within the 5 year period following his approval, then fails to either file his returns on time or has tax debts with the IRS, then his Offer in Compromise will be automatically revoked, and he will owe his entire tax debt plus penalty and interest.

So, my goals are two-fold with every tax client:  (1) to reduce my client’s tax bill in the future, and (2) to come up with a strategy to pay estimated taxes going forward.

Limiting the Self-Employment Tax

When you are a Schedule C filer, you will have to pay self-employment taxes, which are funds that go to the Social Security and Medicare.  In 2017, this amount is 12.4 per cent of all employment income up to $127,200 for Social Security and 2.9 per cent for Medicare.

One way to reduce the self-employment tax burden is to set up an LLC or S-Corporation and take a Sub-chapter S election with the IRS.  By doing this, you can have all income paid to your LLC or corporation, and then your LLC or corporation can pay you a “reasonable salary” and thereby reduce the self-employment tax burden because your remaining income from the corporation would be paid out to you as a dividend.

Please be forewarned that this strategy does not help all taxpayers.  In other words, if you have just started a new business and you’re not yet making sufficient income, then simply setting up a new corporate entity (either an LLC or a corporation) might be creating undue administrative burdens.

A Case Study

Joe had a successful remodeling business but he had always operated as a sole proprietor.  He was a Schedule C tax filer, which meant that he owed 15.3 per cent of all of his income up to $127,200 in self-employment taxes.  That tax bill alone would be $19,461.

By establishing an LLC, he would have all of his customers make their payments not to him, but rather to his new LLC entity.  He would then put himself on a reasonable salary, which for his industry would be around $35,000 a year.     By doing that, he reduces his yearly Social Security and Medicare tax bill to $5,355, which is a substantial savings.

Putting Himself on Payroll

The second big advantage to being on payroll is that Joe is no longer making quarterly estimated tax payments.  Instead, once every two weeks or once a month, he is having a payroll company, or his accountant, handle his payroll.   Let’s say if Joe’s overall income for the year will be $100,000, then he will still owe a considerable amount of federal income tax over and above the $5,355 that I stated above.  He can direct his payroll company to increase his tax deductions to take care of all of his tax burden so that he doesn’t incur any under-payment penalties with the IRS at year’s end.

The overall plan is set up to automate all of Joe’s tax duties.  Yes, he will incur a modest (but deductible) expense by hiring a payroll company.  But, remember that this will leave Joe with the sense of peace and permit him to focus on more profitable ventures with his business instead of worrying about tax obligations that he’s not ideally suited to worry about.

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